How Do Consumers Make Choices?

How do you make the best choice in conditions of scarcity?

◦ In other words, how do you get the “biggest bang for your buck?”

Consider questions like:

◦ Why do people purchase more of something when its price falls?
◦ Why do people buy more goods and services when their budget increases?

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 Consumer Choice and Utility
Table 1. U.S. Consumption Choices in 2015
Consumer choice: the combination of goods and services Average Household Income
a consumer purchases $62,481
before Taxes
Economists look at what consumers can afford with a Average Annual Expenditures $48.109
budget constraint (or budget line), and the total Food at home $3,264
utility or satisfaction derived from those choices
Food away from home $2,505
Housing $16,557
Apparel and services $1,700
Transportation $7,677
Healthcare $3,157
Entertainment $2,504
Education $1,074

Personal insurance and pensions $5,357

All else: alcohol, tobacco,

reading, personal care, cash $3,356
contributions, miscellaneous
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 Consumer Choice and the Budget
Constraint

Imagine that José likes to collect T-shirts and watch

movies
◦ the quantity of T-shirts is shown on the horizontal axis
◦ the quantity of movies is on the vertical axis

The specific choices along the budget constraint line

show the combinations of affordable T-shirts and
movies

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 Utility
Table 2. Total Utility
Utility: the satisfaction or happiness a
person gets from consuming a good or
T-Shirts Total Movies Total
service
(Quantity) Utility (Quantity) Utility
◦ José obtains utility from consuming T-
1 22 1 16 shirts and consuming movies

2 43 2 31 The second column shows the total

utility, or total amount of satisfaction
3 63 3 45

4 81 4 58

5 97 5 70

6 111 6 81

7 123 7 91

8 133 8 100
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 Total Utility
This is a typical total utility curve showing an increase in
total utility as consumption of a good increases, though at a
decreasing rate
Total utility follows the expected pattern: it increases as the
number of movies that José watches rises
Calculate total utility by multiplying the utility of each good
by the number of goods, then adding that together.
◦ Three T-shirts are worth 63 utils. Two movies are worth 31
utils.
◦ Total utility of 94 (63 + 31).

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 Marginal Utility versus Total Utility
A choice at the margin is a decision to do a little more or a little less of something
Marginal utility is based on the notion that individuals rarely face all-or-nothing decisions
◦ The change in total utility from consuming one more or one less of an item
◦ The marginal utility of a third slice of pizza is the change in satisfaction one gets when eating the third slice
instead of stopping with two

Marginal thinking: “How much better will I do on an exam if I study for one more hour?”

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Calculating Marginal Utility
Marginal Utility is equal to the change in total utility divided by the change in quantity

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 Marginal Utility vs. Total Utility
Marginal utility decreases as consumption of a good
increases
This is an example of the law of diminishing marginal
utility, which holds that the additional utility decreases
with each unit added
Diminishing marginal utility is another example of the
more general law of diminishing returns

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 Rules for Maximizing Utility
Consumer equilibrium: comparing the trade-offs
between one affordable combination with all the
other affordable combinations
◦ that is, the combination of goods and services that will
maximize an individual’s total utility

José has income of $56. Movies cost $7 and T-shirts

cost $14. The points on the budget constraint line
show the combinations of movies and T-shirts that
are affordable

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Applying the Rule
To maximize total utility, spend each dollar on the item which yields the greatest marginal utility
per dollar of expenditure
José’s first purchase will be a movie. Why?
◦ José’s choices are to purchase either a T-shirt or a movie
◦ The first movie gives José more marginal utility per dollar than the first T-shirt, and because the movie is
within his budget, he will purchase a movie first

José will continue to purchase the good which gives him the highest marginal utility per dollar
until he exhausts the budget

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 Rules for Maximizing Utility cont.
Table 1. A Step-by-Step Approach to Maximizing Utility

Marginal Gain and Loss of

Try Which Has Total Utility Utility, Compared with Previous Conclusion
Choice
4 T-shirts and 0 81 from 4 T-shirts + 0
Choice 1: P – –
movies from 0 movies = 81
Loss of 18 from 1 less T-shirt, but
3 T-shirts and 2 63 from 3 T-shirts + 31
Choice 2: Q gain of 31 from 2 more movies, Q is preferred over P
movies from 0 movies = 94
for a net utility gain of 13
Loss of 20 from 1 less T-shirt, but
2 T-shirts and 4 43 from 2 T-shirts + 58
Choice 3: R gain of 27 from two more R is preferred over Q
movies from 4 movies = 101
movies for a net utility gain of 7
Loss of 21 from 1 less T-shirt, but
1 T-shirt and 6 22 from 1 T-shirt + 81
Choice 4: S gain of 23 from two more S is preferred over R
movies from 6 movies = 103
movies, for a net utility gain of 2
Loss of 22 from 1 less T-shirt, but
0 T-shirts and 8 0 from 0 T-shirts + 100
Choice 5: T gain of 19 from two more S is preferred over T
movies from 8 movies = 100
movies, for a net utility loss of 3

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 Decision Making by Comparing Marginal Utility
How José could use the following thought process (if he thought in utils) to make his decision regarding how
many T-shirts and movies to purchase:
Step 1: From Table 1, José can see that the marginal utility of the fourth T-shirt is 18. If José gives up the
fourth T-shirt, then he loses 18 utils
Step 2: Giving up the fourth T-shirt, however, frees up $14 (the price of a T-shirt), allowing José to buy the first
two movies (at $7 each)
Step 3: José knows that the marginal utility of the first movie is 16 and the marginal utility of the second
movie is 15. Thus, if José moves from point P to point Q, he gives up 18 utils (from the T-shirt), but gains 31
utils (from the movies)
Step 4: Gaining 31 utils and losing 18 utils is a net gain of 13. This is just another way of saying that the total
utility at Q (94 according to the last column in Table 1) is 13 more than the total utility at P (81)
Step 5: So, for José, it makes sense to give up the fourth T-shirt in order to buy two movies

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 A Rule for Maximizing Utility
This process of decision making described previously suggests a rule to follow when maximizing
utility
Since the price of T-shirts is not the same as the price of movies, it’s not enough to just compare the
marginal utility of T-shirts with the marginal utility of movies
We need to control for the prices of each product
We can do this by computing and comparing marginal utility per dollar of expenditure for each
product
Marginal utility per dollar is the amount of additional utility José receives given the price of the
product

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 Income Changes and Consumption
Choices
The graph shows Jazmin’s budget constraint
◦ Concert tickets are $50 each and going to a bed-and-
breakfast is $200 per night

Jazmin has $1,000 per year to spend between these two

choices:
◦ Jazmin could spend all of her budget on concert tickets, in
which case she could buy $1000/$50 = 20 concert tickets
◦ She could spent all of her budget on nights at a bed-and-
breakfast, in which case she could afford $1000/200 = 5
nights

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 A Rise in Income
What if Jazmin’s income rises to $2,000 per year?
◦ All choices on the upper left of the new budget constraint
that are to the left of the vertical dashed line involve less of
the good on the horizontal axis but much more of the good
on the vertical axis
◦ All choices to the right of the vertical dashed line and above
the horizontal dashed line have more consumption of both
goods
◦ All choices that are to the right of the vertical dashed line
but below the horizontal dashed line involve less of the
good on the vertical axis but much more of the good on the
horizontal axis

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How Changes in Income Affect Consumer Choices
Goods and services are called normal goods if a rise in income leads to a rise in the quantity
consumed of that good and a fall in income leads to a fall in quantity consumed
◦ Depending on Jazmin’s preferences, a rise in income could cause consumption of one good to increase
while consumption of the other good declines

Goods where demand declines as income rises (or conversely, where the demand rises as
income falls) are called inferior goods.
◦ An inferior good occurs when people trim back on a good as income rises

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 How Price Changes Affect Consumer Choices

Sergei chooses between purchasing baseball bats and

cameras
What would happen if there is a A price increase for
baseball bats?
◦ It would have no effect on the ability to purchase cameras, but
it would reduce the number of bats Sergei could afford to buy

This causes the budget constraint to rotate inward, as if on a

hinge, from the vertical axis

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How a Change in Price Affects Consumption
Choices
The substitution effect occurs when a price changes and consumers have an incentive to consume less of the
good with a relatively higher price and more of the good with a relatively lower price
The income effect is that a higher price means, in effect, the buying power of income has been reduced
(even though actual income has not changed), which leads to buying less of the good (when the good is
normal)
◦ Both effects can occur simultaneously

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 Indifference Curves
An indifference curve shows all combinations of goods
that provide an equal level of utility or satisfaction
Each indifference curve (Ul, Um, and Uh) represents one
level of utility
The indifference curve Um has four points labeled on it:
A, B, C, and D
Consider Lilly’s preferences for the tradeoffs that she
faces in her two main relaxation activities: eating
doughnuts and reading paperback books

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 The Shape of an Indifference Curve
Since an indifference curve represents a set of choices that have the same level of utility, Lilly must receive an
equal amount of utility
She would also receive the same utility from any of the unlabeled intermediate points along this indifference
curve
Indifference curves have a roughly similar shape in two ways:
1. They are downward sloping from left to right
2. They are convex with respect to the origin. In other words, they are steeper on the left and flatter on the right

The downward slope of the indifference curve means that Lilly must trade off less of one good to get more of
the other, while holding utility constant

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The Field of Indifference Curves
Each indifference curve represents the choices that provide a single level of utility
Every level of utility will have its own indifference curve
Lilly’s preferences will include an infinite number of indifference curves lying nestled together on
the diagram
These arguments about the shapes of indifference curves and about higher or lower levels of
utility do not require any numerical estimates of utility

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The Individuality of Indifference Curves
Each person determines his or her own preferences and utility
While indifference curves have the same general shape—they slope down, and the slope is
steeper on the left and flatter on the right—the specific shape of indifference curves can be
different for every person
People seek the highest level of utility, which means that they wish to be on the highest possible
indifference curve, but people are limited by their budget constraints

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 Maximizing Utility at the Highest Indifference
Curve
Say that books cost $6, doughnuts are 50 cents each, and
that Lilly has $60 to spend
The choice of F with five books and 100 doughnuts is highly
desirable, since it is on the highest indifference curve Uh
However, it is not affordable given Lilly’s budget constraint
The choice of H with three books and 70 doughnuts on
indifference curve Ul is a wasteful choice
Lilly will always prefer a choice on the budget constraint itself

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